Fusion for profit how marketing and finance can work together to creat value

To achieve this goal, Fusion for Profi t focuses on developing comprehensive business mod-els that integrate the diff erent functional areas in the fi rm e.g., marketing, fi nance, producti

Fusion for Profi t 

How Marketing and Finance Can Work Together

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Library of Congress Cataloging-in-Publication Data

Jagpal, Sharan, 1947–

Fusion for profi t : how marketing and fi nance can

work together to create value / by Sharan Jagpal;

with the assistance of Shireen Jagpal.

my family and friends

but if he will be content to begin with doubt

he shall end in certainties.

—Francis Bacon (1561–1626)

Fusion for Profi t is a one-of-a-kind exposition of how the fusion of marketing

skill and fi nancial discipline can drive shareholder value Sharan Jagpal has written a highly readable book that is buttressed by fascinating examples and easy-to-understand “Maxims.” Th is superb book is a must read for anyone interested in building businesses Global and domestic markets today are highly competitive and equally complex Within this environment, fi rms both large and small are faced with confl icting objectives, blinding uncer-tainty, and multifaceted challenges, and managers are constantly struggling with confounding questions such as the following:

Which products should be supported?

How best to compensate a sales force in a single-product situation

•

versus a multiproduct portfolio?

What is the value of a brand? How best to build further brand equity?

Many organizations resemble a multihanded Hindu goddess, where one hand is blithely unaware of what the others are doing It then falls upon the COO or CEO to coordinate and align these disparate activities, causing

duplication of work and wasted energy Fusion for Profi t is full of insightful

observations, detailed examples, and pithy maxims that will be invaluable for managers It will persuade management to take a more holistic view of business problems and drive streamlined solutions to issues that aff ect the entire organization Th e resulting improvement in effi ciency and productiv-ity would be signifi cant

Sharan Jagpal prefaces his book with a quotation from Francis Bacon (1561–1626): “If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubt he shall end in certainties.”

Th ese words beautifully capture the spirit of Fusion for Profi t If you have

doubts, go right away into the corridors of this fi nely written book

Dinyar S Devitre Senior Vice President and Chief Financial Offi cer,

Altria Group, Inc.

New York

7 January 2008

Business is ideally about serving customers well while delivering good value

to shareholders But like many ideals, when it comes to cases in the real world, the actual service a customer receives is often encumbered by the invisible boundaries that separate diff erent business functions such as mar-keting and fi nance

Th ese impediments to customer service result from confi ning marketing and fi nance in “silos” that operate separately and often act independently

In addition to the main divide between them, each of these core business functions also has its own set of internal boundaries Within marketing, for example, for years there has been a traditional line between brand advertis-ing and direct marketing Comparable lines within fi nance divide supply and distribution However, across both marketing and fi nance, the rapid and continuous changes in information systems and customer control are quickly making all such boundaries disappear

More than 30 years ago, strategy guru Peter Drucker recognized that the purpose of business is to create a customer Based on that goal, he said,

“Th e business enterprise has two—and only two—basic functions: ing and innovation.” Th roughout my years in both the manufacturing and services sectors, I have tried to let this profound observation guide me in making resource allocation decisions and developing performance measure-ments In my experience, senior executives in every industry and segment are looking for ways to increase measurability of their marketing campaigns,

market-assign more accountability for marketing results, and earn a better return on marketing investment.

Innovation can result from testing new theories and evolving new and improved metrics to quantify and choose the right mix of risk and return to maximize shareholder value What is the cost of acquiring a new customer? What is the lifetime fi nancial value of a customer? How can we use this infor-mation to choose strategies that will maximize shareholder value? Answering these questions will require new empirical methods that cut across silos and boundaries—innovations that can fuse marketing and fi nance

In Fusion for Profi t, Professor Jagpal brilliantly combines these

seem-ingly disparate fi elds and proposes novel new theories and methods, many of them quite sophisticated Even so, his ideas and messages are accessible to a wide audience because, in addition to presenting his complex ideas as simply

as possible, he has done it without using any math or algebra!

Bringing marketing and fi nance together is a massive endeavor, ing this book unique in its scope and the breadth of the topics it covers Although not written as a handbook, it is suffi ciently comprehensive to be used as one If you seek overall guidance, you will fi nd an in-depth and holis-tic look at all the options a business faces in today’s world, examining each from multiple perspectives within marketing and fi nance

mak-Why is this work so important? I can suggest at least two reasons.First, if marketing and fi nance continue to operate in diff erent silos, they will be leaving money on the table Simply stated, the more marketers understand fi nance—and vice versa—the stronger their shared competitive capabilities can become Th is means they will be better than others at creat-ing a customer, as Drucker puts it, which adds up to shareholder value

A second, more complex reason embodies all the changes in today’s business environment that have put consumers in control of the relation-ships they will allow business or nonprofi t organizations to have with them Consumers in both their business and personal lives demand communica-tions that are relevant to their individual needs and preferences, and they insist that marketing be done responsibly—respecting their time, attention, and privacy When marketing and fi nance can fuse, they can better meet these needs and deliver great results

Regardless of whether you work in marketing or fi nance, wherever you stand in your career development, this book will provide you with the theo-ries and methods you need to be successful in taking a holistic approach to your business

John A Greco Jr President and CEO, Direct Marketing Association

New York

16 November 2007

Why Should You Read This Book?

Most books in business focus on specifi c subareas such as marketing, fi nance, and human resources management Furthermore, the coverage tends to be diff use At one end of the academic spectrum, some books focus on develop-ing highly technical “ivory tower” theories that are diffi cult to use in prac-tice or require information that is not readily available At the other end of the spectrum, some books provide simplistic box-and-arrow fl owcharts (“models”) specifying how constructs or business functions relate to one another

Th ese models have limited value to the manager or executive because they do not specify metrics for measuring key constructs Nor do they pay suffi cient attention to the quantitative eff ects of real-world complications introduced by such factors as error in measuring key constructs, uncertainty, and incomplete information

Practitioner books, in contrast, tend to be anecdotal Specifi cally, they provide detailed accounts of strategies that have been used by a “successful”

fi rm or fi rms in a specifi c industry and exhort managers or executives to follow these “best practices.”

Th is backward-looking and inductive approach is misleading As casual empiricism shows, strategies that have been successful in the past are often

a recipe for poor performance in the future Alternatively, some practitioner

books exhort the fi rm or organization to use blanket strategies that are in vogue (e.g., strategies based on cost-cutting or outsourcing) Th ese strategies, however, are easily imitated by competitors Consequently, by pursuing this approach, the fi rm or organization will not be able to achieve superior long-run results Th e net result is that, despite the voluminous business literature, managers (including owner managers) and executives are left with little guid-ance on how to choose comprehensive strategies that deliver long-run value.

Fusion for Profi t attempts to fi ll this vacuum by bridging the current gap

between the academic and business practitioner literatures To achieve this

goal, Fusion for Profi t focuses on developing comprehensive business

mod-els that integrate the diff erent functional areas in the fi rm (e.g., marketing,

fi nance, production, and engineering) In addition, the book develops tical methods for improving business decision making that can be imple-mented using readily available data

prac-From a business practitioner’s viewpoint, the goal is to unlock the ivory tower

and provide managers at all levels in the fi rm or organization with

knowl-edge of state-of-the-art theories and empirical methods that go beyond their functional areas and areas of specialization Consequently, by using these integrated theories and empirical methods, managers can overcome the bar-riers posed by functional specialization and work together to develop and implement strategies that maximize the long-run performance of the fi rm.From an academic viewpoint, the goal is to provide a comprehensive set of theories and empirical methods that can be used for both strategic and tactical decision making at diff erent levels in the fi rm or organization Th roughout the book, particular emphasis is given to measurability and the impact of measurement error and incomplete information on decision making

What Is

Fusion for Profi t?

Fusion for Profi t is a new approach to decision making that goes beyond the

constraints imposed by “silo” eff ects in business and academe Th e rate world is typically structured in function-based silos While this type of structure is convenient and may smooth the daily functioning of an organi-zation, the CEO and senior management are left with the task of integrating all functions within the organization and focusing on the “big picture” (in this case, shareholder value)

corpo-Th e academic world tends to be structured in discipline-based silos (e.g., marketing and fi nance) or subdiscipline-based silos (e.g., the eff ect of adver-tising on long-term memory) Because of this ultraspecialization in academe, insuffi cient attention is given to developing comprehensive models of the

fi rm that explicitly consider the interface among diff erent functional areas, including marketing and fi nance

Although we shall focus heavily on marketing-fi nance fusion, Fusion for Profi t has a much broader scope Many of the concepts and theories in the

book can be applied to the interface among marketing, fi nance, and other functional areas in the fi rm, including human resources, engineering, and production.

Who Should Read

Fusion for Profi t?

Fusion for Profi t provides integrated cross-functional solutions to a wide

range of short- and long-run problems facing the fi rm Hence it should be of interest to managers at all levels in the organization, academics, and students

in diff erent disciplines (e.g., marketing, fi nance, economics, and strategy)

In order to make the material accessible to diverse audiences, I have not used any mathematics or algebra in the book Th roughout, the attempt is

to provide intuition without sacrifi cing rigor Wherever necessary, technical references have been added for the interested reader

As a glance at the table of contents will show, Fusion for Profi t covers a

wide spectrum of topics, many of which are not covered in standard books

Th e reader should peruse the table of contents to obtain a comprehensive overview of the scope of the book and then decide which topics are directly relevant to his or her position in the organization

Following is a highly abbreviated sampling of topics that are covered in the book Th ese topics should be of interest to diff erent audiences (i.e., business executives at all levels in the publicly held fi rm, owner managers, academics

in diff erent functional areas, and students in diff erent disciplines, including marketing, economics, fi nance, and organizational management)

Managers

The Chief Executive Offi cer (CEO)

How should the fi rm measure the productivities of divisional

•

managers, and how should these managers be compensated?

Should the fi rm set up manufacturing operations immediately, or

The Chief Marketing Offi cer (CMO)

How should the fi rm choose a product positioning and advertising

•

strategy that maximizes its long-run performance?

How should the fi rm coordinate the marketing, engineering, and

•

fi nance functions to determine the optimal mix of products and

product designs?

How should the fi rm measure the risks and returns from using a

multi-•

channel distribution strategy?

The Chief Financial Offi cer (CFO)

What fi nancial criteria should be used to allocate resources across

tion of cash fl ows for other products in the fi rm?

The Chief Operating Offi cer (COO)

How should the fi rm develop and design product bundles based on its

The Chief Technology Offi cer (CTO)

How should the fi rm integrate the R & D and marketing functions in

•

order to translate technology into real customer advantages?

How should the fi rm determine the risks and returns from choosing

•

diff erent product portfolios based on a particular technology?

How can the fi rm determine the value of the technical synergies

•

from acquiring a target company and rank that company against its competitors?

The Chief Information Offi cer (CIO)

How should the fi rm measure the performance of multichannel

distri-•

bution strategies (e.g., bricks-and-mortar stores and the Internet)?How should the fi rm measure the performance of its advertising strat-

•

egy across conventional media and the Internet?

How should the fi rm measure the short- and long-run productivities of

•

its call centers?

The Product Manager

Prior to the launch of a new product, how can the fi rm use self-stated

tions on cannibalization and the market shares of competitors?

How should the fi rm coordinate its marketing policies when it

intro-•

duces new products sequentially into the marketplace?

The Advertising Manager

How should the advertising budget be allocated over time and across

•

media (e.g., conventional media and the Internet)?

What metrics should be used to measure advertising productivity

•

for conventional media? What metrics should the fi rm use to

measure advertising productivity for the Internet? And, how should

these decisions factor in measurement error and joint eff ects across

media?

How should the fi rm determine whether to prepurchase advertising

•

space in the future? And, what proportion of the advertising

budget should be spent on prepurchasing advertising in diff erent

media?

The Sales Manager

How should the multiproduct fi rm determine the optimal

compensa-•

tion plans for its sales force?

How should compensation plans be adjusted when the salesperson’s

•

eff ort has an eff ect on future sales and profi ts?

Under what conditions should sales revenue be used as a proxy of a

•

salesperson’s productivity?

The Pricing Manager

How should the fi rm determine what prices to charge for individual

•

products and product bundles?

How should the fi rm price a new product it is planning on adding to

•

its existing product line?

How should the fi rm price a product when some consumers or

con-•

sumer segments have incomplete information?

The Mergers and Acquisition (M & A) Manager

How should the fi rm determine the brand equity of a target brand or

•

company that it plans to acquire?

Under what conditions is it desirable for one fi rm to acquire another

•

fi rm with low brand equity?

How should the fi rm determine whether an international acquisition

•

or merger will increase the long-run value of the fi rm?

The Owner of a Privately Held Firm

What is the appropriate measure of risk and return to the owner from

•

pursuing diff erent marketing strategies?

Should the privately held fi rm modify its strategy diff erently from a

•

publicly held fi rm when market conditions change?

Under what conditions will productline and/or geographical diversifi

-•

cation (domestic or international) help the privately held fi rm?

The Social Marketer

Under what conditions does advertising make society better off ?

•

Under what conditions will consumers and society be better off in the

•

long run when fi rms distribute free samples?

Are consumers and society better off when fi rms introduce product

•

upgrades of durable products?

Academics

As noted earlier, Fusion for Profi t covers a wide range of topics that are not

addressed in conventional books Furthermore, the treatment of standard

topics (e.g., pricing) is nontraditional Since Fusion for Profi t focuses on

pro-viding integrated solutions to a wide class of business problems, it should be

of interest to academics in a number of fi elds, including marketing, fi nance, economics, human resource management, and strategy

Students

Over the last 35 years, I have taught a large number of graduate students in the United States and abroad During this period, I have heard the frequent refrain from many MBA and executive MBA students that standard busi-ness courses provide limited guidance in solving the real-world problems that they face (e.g., the decision-making problems posed by measurement

error and incomplete information) Fusion for Profi t addresses this gap by

focusing on how to develop actionable strategies that are comprehensive, allow for incomplete and imperfect information, and integrate diff erent

functional areas in the fi rm To make the ideas in Fusion for Profi t readily

accessible to students, all topics are discussed using a question-and-answer format

How Should You Read

Fusion for Profi t?

Fusion for Profi t can be read in diff erent ways As the table of contents shows,

the material in the book has been partitioned so that each chapter focuses

on a particular managerial topic (e.g., the use of the market share metric for choosing marketing strategies or how to allocate resources across diff erent product lines or market segments) Consequently, it is not necessary to read the chapters in sequence

Alternatively, if your goal is to obtain a quick overview of the book, you should focus on the “Fusion for Profi t Maxims” and the key points at the end

of any chapter of interest Should you decide to study a particular topic in depth, read the sections of interest in the relevant chapters.

Each chapter uses a question-and-answer format and is structured in the same way for readability:

When and why the information in the chapter will be useful,

Because of the wide scope of the topics covered in Fusion for Profi t and

its strong multidisciplinary focus, I have added an extensive glossary, which includes defi nitions of terms from a number of fi elds, including economics,

fi nance, marketing, strategy, psychometrics, and statistics Since some of the

topics covered in Fusion for Profi t are highly specialized (e.g., the role of

private equity fi rms in mergers and acquisitions and the pricing of Internet advertising), the glossary also includes a number of terms that are not easily accessible to most readers

Finally, Fusion for Profi t provides an in-depth analysis of, and solutions

to, a wide range of key problems facing managers in diff erent functional areas and senior management Importantly, throughout the book we empha-size the critical relationships among the diff erent functional areas in the fi rm, including marketing and fi nance Consequently, you may fi nd it convenient

to keep Fusion for Profi t as a handbook.

Acknowledgments

In alphabetical order, I would like to thank Dinyar Devitre (Senior Vice President and CFO, Altria Group, Inc.); John A Greco Jr (President and CEO, Direct Marketing Association); David Luenberger (cofounder of the Department of Engineering-Economic Systems at Stanford University); Harry Markowitz (Nobel laureate in economics and inventor of modern portfolio theory in fi nance); Edward J Mishan (emeritus professor, London

School of Economics), and Don Morrison (founding editor of Marketing Science, the leading marketing journal internationally, and Leonhard

Professor of Management, UCLA) for encouraging me to write a book on the marketing-fi nance interface that helps to bridge the gap between prac-tice and academe, is rigorous but intuitive, and supplements the theory and concepts with real-world examples

I also thank my family for their critical reading of the manuscript and for forcing me to write more clearly In alphabetical order I thank Mohini (my wife), Ruby (my sister), and Shireen (my daughter) Shireen, in particular,

has provided valuable insight as a corporate executive, suggested a number

of topics to be included in the book, provided incisive substantive comments, and made numerous editorial improvements

Finally, I thank Linda Donnelly and Susan Ecklund (production editor and copyeditor, respectively) for their help

I hope you enjoy reading Fusion for Profi t and fi nd it useful for

errors

Foreword ix

Dinyar S Devitre

Foreword xi

John A Greco Jr.

Part I Financial Tools Necessary for Understanding

the Marketing-Finance Interface

1 Choosing Marketing Policy in the Short Run 5

1.1 Should the Firm Use Profi ts to Choose Marketing Policies? 6

1.2 Should the Firm Use the Return on Investment Criterion for Marketing

Decision Making? 7

1.3 How Does the Ownership Structure of the Firm Affect How Marketing

Policies Should Be Chosen? 10

1.4 What Does the Risk-Adjusted ROI Criterion Imply for Multiproduct and

Multidivisional Firms? 17

2 Choosing Marketing Policy in the Long Run 19

2.1 How Should the Firm Choose Long-Run Marketing Policies under

Certainty? 20

2.2 How Should the Firm Choose Long-Run Marketing Policies under

Uncertainty? 23

2.3 How Should the Firm Measure the Long-Run Effects of Different

Marketing Policies? 25

2.4 How Should the Multiproduct Firm Choose Long-Run Marketing Policies

under Uncertainty? 27

2.5 How Should the Firm Make Long-Run Strategic Marketing Decisions

under Uncertainty When It Has Strategic Flexibility? 28

2.6 How Should the Firm Measure and Reward Managers When It Has

Strategic Flexibility in Choosing Marketing Policies? 33

Part II Defi ning the Market

3 What is the Impact on Strategy? 39

3.1 In What Market Does the Firm Compete? 40

3.2 How Does the Defi nition of the Market Affect the Firm’s Marketing

Strategy? 43

3.3 How Does the Firm’s Defi nition of the Market Affect Managerial

Incentive Schemes? 44

Part III Understanding Market Shares

4 Should the Firm Pursue Market Share? 47

4.1 Why Do Firms Pursue Market Share? 48

4.2 Does an Increase in Market Share Lead to Higher Short-Run Profi ts? 49

4.3 When Does an Increase in Market Share Lead to Higher Long-Run

Profi ts? 53

4.4 Should the Firm Enter High-Growth Markets? 55

4.5 Should the Firm Pursue Market Share in a High-Growth Market? 56

4.6 Should the Firm Attempt to Increase Its Volume-Based Market Share

in the Short Run When Cost Dynamics Are Present? 57

4.7 Should the Firm Pursue Volume-Based Market Share When Demand

Dynamics Are Present? 61

4.8 Should the Firm Pursue Market Share If Neither Cost Nor Demand

Dynamics Are Present? 63

4.9 Should the Firm Pursue Market Share by Being the Pioneer in Its

Industry? 66

4.10 Is It Ever Optimal for the Firm to Keep Its Volume-Based Market

Share Low? 68

5 Should the Multiproduct Firm Use the Market Share Metric? 78

5.1 Market Share and Pricing for the Durable Goods Manufacturer That Sells

Spare Parts 79

5.2 Market Share and Pricing for the Firm That Sells After-Sales Contracts 80

5.3 How Does Uncertainty Affect Pricing Policy and Market Share for the

Firm That Sells Proprietary Spare Parts or After-Sales Contracts? 81

5.4 Should the Firm That Introduces Product Upgrades over Time Pursue

Market Share or Current Profi ts? 82

5.5 How Should the Firm Change Its Market Share and Long-Run Pricing

Policy When Competitors Introduce New Products? 84

5.6 Should the Firm Focus on Market Share If It Sells Products That Must Be

Used Together? 85

5.7 Should the Multiproduct Firm Allocate Resources across Products on the

Basis of Their Respective Market Shares? 86

Part IV Strategies and Pricing Policies for New Products

and Product Bundles

6 Pricing New Products: Strategies and Caveats 93

6.1 Can the Firm Price a New Product to Maximize Its Profi tability? 94

6.2 How Should the Firm Price a New Product under Uncertainty? 96

6.3 How Does the Firm’s Ownership Structure Affect New Product

6.6 Should Firms Preannounce Their New Products? 108

7 Choosing Strategies for New Products Using Market-Level

Data 112

7.1 Which Product Qualities Should the Firm Produce? 113

7.2 Choosing New Product Strategy: The Case Where Consumers Are Fully

Informed 115

7.3 Choosing New Product Strategy: The Case Where Consumers Are Not

Fully Informed 119

7.4 Choosing New Product Strategy: The Case Where Some Consumers Are

Well Informed but Others Are Not 120

8 Choosing Strategies for New Products Using Primary Data 124 8.1 Controlled Purchase Experiments 125

8.2 Intentions Studies 127

8.3 Preference and Choice Studies 131

8.4 Estimating Demand Using Reservation Prices 134

8.5 Estimating the Demand for New Products Using Self-Stated Reservation

Prices 139

8.6 Estimating the Demand for New Products by Inferring Reservation

Prices 141

8.7 Measuring Reservation Prices Using Auctions 146

8.8 When Should Firms Use Auctions? 148

8.9 Perceptions and New Product Demand 148

8.10 How Useful Are Experiments for Measuring New Product

9.2 When Should Firms Use a Bundling Strategy? 159 9.3 Bundling and Cross-Couponing Strategies 164 9.4 Applications of Bundling Theory 170

9.5 Why Do So Many Bundling Strategies Fail? 177

9.6 How Can the Firm Improve the Chances That a Bundling Strategy Will

Succeed? 178

Part V Integrating Marketing Strategy and the Supply Chain

10 Channels of Distribution 183

10.1 Choosing a Channel Strategy 184

10.2 Choosing a Channel Strategy Using an Exclusive Distributor: The Case

Where the Manufacturer Has Economic Power 185

10.3 Choosing a Channel Strategy Using an Exclusive Distributor: The Case

Where the Distributor Has Economic Power 191

10.4 Coordinating Price and Advertising Decisions in the Channel 193

10.5 Channel Strategy in the Multiproduct Case 195 10.6 Choosing Channel Strategy Using Multiple Exclusive Distributors 198 10.7 Choosing Channel Strategy Using Nonexclusive Distributors 200 10.8 Should the Firm Use a Vertical Integration Strategy? 201 10.9 Long-Term Channel and Supply Chain Strategy 203

Part VI Marketing Policy and Consumer Behavior

11 How Does Consumer Behavior Aff ect Marketing Policy? 207 11.1 What Is the Standard Economic Model of Consumer Choice? 208

11.2 Is the Standard Economic Model of Consumer Choice Good Enough for

11.7 Implications of Prospect Theory for the Human Resources

Manager 227 11.8 Implications of Prospect Theory for Financial Markets 229

11.9 What Metrics Should the Firm Use to Evaluate Consumer

Behavior? 231

Part VII How to Choose Advertising and Promotion Strategies

12 Coordinating Advertising Strategy, Branding, and

Positioning 237 12.1 What Is Product Positioning? 238 12.2 Choosing Advertising Message Strategy 239 12.3 Measuring the Effectiveness of an Advertising Message 247

12.4 Managerial Implications for Branding and Positioning Existing

Products 252

12.5 Managerial Implications for Positioning New Products and Rebranding

Existing Products 258

12.6 How Should the Firm Coordinate Its Advertising Message Strategy with

Other Marketing Decision Variables? 263

13 Determining the Advertising Budget 265

13.1 Advertising and Marketing Strategy 266

13.2 How Should the Firm Coordinate Its Price and Advertising Decisions?

Some Basic Concepts 269

13.3 How Should the Firm Coordinate Its Price and Advertising Policy to

Maximize Short-Run Performance under Certainty? 274

13.4 Implications for Choosing Advertising Policy over the Product Life

Cycle 275

13.5 How Should the Firm Vary Its Price and Advertising Policies over the

Business Cycle? 279

13.6 How Should the Firm Coordinate Its Price and Advertising Policy in the

Short Run When Demand Is Uncertain? 280

13.7 How Should the Firm Coordinate Its Price and Advertising in the Long

Run When Demand Is Certain? 282

13.8 Coordinating Price and Advertising in the Long Run When Demand Is

Uncertain 284

13.9 Corporate Image Advertising 284

14 Measuring Advertising Productivity 287

14.1 How Can the Firm Measure Advertising Productivity? 288

14.2 How Can the Firm Measure Advertising Productivity Using Historical

Data? 289

14.3 How Can the Firm Measure the Productivities of Different Advertising

Media? 297

14.4 Measuring Media Productivity Using Reach Models 298

14.5 Measuring Media Productivity Using Gross Rating Point Models 302

14.6 How Much Should the Firm Be Willing to Pay for Advertising in a Given

Medium Based on Standard Commercial Rating Scores? 304

14.7 How Should the Firm Determine When to Purchase Advertising Space

and How Much to Spend on It? 307

14.8 Measuring Media Productivity Using Sales Models 315

14.9 Dynamic Carryover Effects 316

Part VIII How to Choose Compensation Plans

15 How Should the Firm Compensate Managers to Maximize

Performance? 321

15.1 The Single-Product Firm: Short-Run Horizon 322

15.2 The Single-Product Firm: Long-Run Horizon 323

15.3 The Multiproduct Firm: Short-Run Horizon 327

15.4 The Multiproduct Firm: Long-Run Horizon 328

15.5 How Do Wall Street’s Expectations Affect the Firm’s Compensation

Policy? 330

15.6 What Roles Should the Finance Department and Senior Management

Play in Determining the Firm’s Compensation Plans? 330

16 How Should the Firm Compensate Its Sales Force? Th e Basic Model 333

16.1 Reservation Income 334

16.2 How Should the Firm Compensate Its Sales Agent If the Sales Agent’s

Effort Is Observable? 335 16.3 Should the Firm Pay the Sales Agent Using a Draw System? 341

16.4 Should the Firm Pay the Sales Agent on the Basis of Sales Revenue or

Gross Profi ts? 342

16.5 How Does the Firm’s Cost Structure Affect the Sales Force

Compensation Policy? 342

16.6 What Compensation Plan Should the Firm Use When It Delegates

Decision-Making Authority to the Sales Agent? 346

16.7 How Will the Internet Affect the Firm’s Sales Force Compensation

Plan? 348

16.8 What Compensation Plan Should the Firm Use if It Hires the Sales Agent

Using a Multiperiod Contract? 350

17 Model Extensions: How Should the Multiagent/Multiproduct Firm Reward and Measure Sales Force Performance? 356

17.1 How Should the Single-Product Firm with Multiple Salespeople

Compensate Its Sales Force? 357

17.2 How Does the Firm’s Market Segmentation Strategy Affect the Firm’s

Compensation Plan? 359

17.3 How Should the Multiproduct Firm Compensate Its Sales Force? 361

17.4 How Should the Multiproduct Firm Measure Sales Force

Productivity? 366

Part IX How to Allow for Competitive Reaction

18 How to Make Marketing Decisions When Competitors React: A Game-Th eoretic Approach 375

18.1 What Is the Firm’s Objective When Competitors React? 376

18.2 Choosing Optimal Strategies When Competitors React: Basic

18.6 How Useful Is the Game-Theoretic Methodology for Marketing Decision

Making When Competitors React? 399

18.7 How Can the Firm Make Sequential Decisions after Allowing for

Competitive Reaction? 399 Appendix 405

Part X Other Applications of Fusion for Profi t

19 Measuring and Building Brand Equity 413

19.1 When Does Brand Equity Exist? 414

19.2 How Does the Name of a Product Affect Brand Equity? 415

19.3 Brand Name and Pricing Strategy 418

19.4 Strategies for Building Brand Equity 422

19.5 How Can the Firm Measure Brand Equity? 424

19.6 Should the Firm Use a Brand’s Market Share to Measure Brand

20.1 What Is Social Welfare and How Is It Measured? 437

20.2 Is Profi t Maximization Compatible with Maximizing Social

20.6 Are Quantity Discounts Good for Consumers and for Society? 446

20.7 Does Advertising Make Consumers and Society Better Off? 448

20.8 How Does Advertising Affect Consumer Well-Being and Social Welfare

over the Product Life Cycle? 458

20.9 Is Competitive Advertising Good or Bad for Consumers and for

Society? 460

20.10 How Does Product Bundling Affect Consumer Well-Being and Social

Welfare? 464

20.11 Do Consumers and Society Gain When the Firm Introduces New

Models of Its Product over Time? 469

21 Internet Marketing 474

21.1 How Does the Internet Affect Prices? 475

21.2 Will the Internet Lead to Commoditization? 478

21.3 The Internet and Advertising Message Strategy 484

21.4 Measuring the Productivity of Internet Advertising 484

21.5 How Much Should the Firm Be Willing to Spend on Internet

Advertising? 487

21.6 How Should Search Engines Price Internet Advertising? 491

21.7 How Should the Firm Coordinate Its Internet Advertising and Sales Force

Strategies? 495 21.8 How Does the Internet Affect Social Welfare? 498

21.9 How Will the Internet Affect the Advertising Industry in the

Future? 500

22 Mergers and Acquisitions 505

22.1 The Rationale for Mergers and Acquisitions 506 22.2 The Potential Gains from Mergers 507 22.3 Do Intangible Assets Add Value in a Merger? 509 22.4 Do Mergers Work? 512

22.5 Alternative Acquisition Strategies 514 22.6 Brand Equity and Mergers 516 22.7 The Roles of Private Equity Firms and Hedge Funds 524 22.8 International Mergers 527

23 How to Choose Optimal International Marketing

Strategies 531

23.1 Is It Necessary to Develop a Separate Theory of International

Marketing? 533 23.2 What Are the Major Pitfalls in International Marketing? 533

23.3 Under What Conditions Will International Marketing Strategies

23.6 What Is the Role of Country Managers and How Should the Parent

Company Measure and Reward Them? 543

23.7 What Organizational Structure Should the Multinational Firm Use? 550

23.8 How Should the Firm Choose and Implement the Optimal Outsourcing

Financial Tools Necessary for Understanding the Marketing-Finance Interface

Th is chapter and the next will introduce you to some fi nancial tools that are

essential for understanding Fusion for Profi t For simplicity, we will assume that marketing policies (e.g., price and advertising) have short-term eff ects

In the next chapter, we will consider the more general case where the fi rm’s

marketing policies have long-term eff ects.

Th e information covered in this chapter will be useful when you are faced with the following types of decisions:

How should my fi rm measure profi tability under uncertainty?

•

How should my fi rm use the

• return on investment criterion (ROI) for

marketing decision making?

How should my fi rm choose marketing policy if my fi rm is privately held?

products or has multiple divisions?

Th e following terms will be introduced in this chapter (see glossary for defi nitions):

fi nancial cost

hedge fundhurdle rate of return inventory holding cost long-term eff ects

1.1 Should the Firm Use Profi ts to Choose Marketing

Policies?

Before we address this issue, it is necessary to defi ne profi ts Profi t is defi ned as:

profi t = revenue – costs

in any given time period

Is profi t a well-defi ned quantity? How should profi t be computed?

On the surface, profi t appears to be a well-defi ned quantity However, it is easy to mismeasure profi t Th e primary danger is omitting hidden, nonac- counting costs.

Example 1: Consider an entrepreneur who has invested his or her own money in a business Since the fi rm does not have any fi nancial obligations

to outsiders, the accounting cost of this investment is zero However, the

fi nancial cost of this investment is clearly nonzero, since the entrepreneur

could have invested the money elsewhere Similarly, instead of running his

or her own business, the entrepreneur could have taken a job elsewhere Th e income that the entrepreneur forgoes by running his or her own business is a hidden cost that should be deducted from the fi rm’s gross revenues in order

to compute profi ts

Example 2: Consider an electronic retailer who has to decide how many DVD players to order Suppose the retailer orders 50 units and sells 49 Th en,

the retailer faces an inventory holding cost for the one unit that is unsold

However, suppose the retailer orders 50 units, but the demand is 51 units Since the retailer never purchased the 51st unit, the accounting cost of the

51st unit that could have been sold if it were in inventory is zero.

Th e economic cost, however, of the shortage can be considerable It is the

profi t that the retailer could have earned on the 51st unit plus the future profi ts

it could have earned via repeat purchases by that customer In many cases, the economic cost of a shortage can exceed the cost of having unsold inventory

Fusion for Profi t Maxim

Profi t should be computed after considering all relevant costs Standard accounting measures of profi t may be misleading

risk-neutral risk premiumshort-term eff ects uncertainty volatility

Why is the “given time period” important?

Profi t has two dimensions: money and time (e.g., profi t per month or profi t

per year) Unless one specifi es the time period, the profi t maximization criterion is ambiguous

Example: If a high-tech fi rm such as Microsoft seeks to maximize profi t over a short time period (say three months), the optimal level of R & D will

be zero Such a policy is likely to lead to poor long-run performance

Fusion for Profi t Maxim

For profi t maximization to be a meaningful criterion, it is necessary to specify the appropriate time horizon

1.2 Should the Firm Use the Return on Investment

Criterion for Marketing Decision Making?

Th e fi rm’s return on investment for a given product is defi ned as follows:

ROI profit in a given time period

Now suppose the retailer establishes two identical stores by investing a total

of $20 million As one would expect, the retailer’s profi t will increase Let’s say that the retailer’s annual profi t increases from $1 million to $1.5 million per year Th en, the retailer’s ROI from opening two stores is 7.5% (1.5/20 × 100%) Note that when the retailer expands its operations, profi ts increase from

$1 million to $1.5 million However, profi tability (ROI) decreases from 10%

to 7.5% Hence the optimal strategy for the retailer may be to open one store only

As this example shows, the ROI criterion is appealing because it focuses

on profi tability and not on profi ts per se However, in spite of the intuitive appeal of the ROI criterion, one needs to be careful in measuring ROI

Valuation and the Single-Product Firm

Th e metric for investment should refl ect market valuations Consider the following example Suppose Samsung produces semiconductors using an old plant Let’s say that Samsung purchased the plant several years ago Suppose Samsung has taken tax write-off s on the plant and that the plant

has a book value of $1 million (purchase price of $10 million – accumulated depreciation charges of $9 million).

Suppose Samsung expects to make an annual profi t of $1 million by ducing and selling semiconductors made at this plant Th en, the ROI based

pro-on accounting valuatipro-ons is 100% (annual profi t/book value of the plant) Now suppose that, because of robust demand for semiconductors, there is a shortage of plant capacity Hence Samsung can sell its old plant in the mar-ketplace for $5 million (> $1 million) Th en, Samsung’s “true” investment

in the old plant is $5 million Hence, based on market valuations, Samsung’s

annual ROI from the old plant is only 20% (annual profi t/market value of

the plant) Note that the ROI that is based on accounting data (100%) is seriously overstated

Fusion for Profi t Maxim

ROI should be measured based on the market value of an investment and not

on its book value

Point to consider. What are the policy implications of using historical valuations to measure ROI?

In general, book values and market values will diff er Suppose that the book values of old plants are lower than the corresponding market values

Th en, the fi rm will overstate the ROIs of old plants Consequently, it will allocate too many resources to old plants and too few to new plants In addi-tion, the fi rm will use the wrong performance metrics to measure and reward managerial performance Th us, for purely fortuitous reasons, the fi rm will reward managers of old plants for “superior” performance and penalize man-agers of new plants for performing poorly

Multiple Products. Th e standard ROI metric should be adjusted if the fi rm’s product lines are related either on the demand side or on the cost side

Example 1: AOL generates revenue from selling Internet tions and from advertising revenue generated from AOL’s Web site Since AOL’s advertising revenue is based on the number of AOL’s paid subscrib-ers, the standard single-product measure of ROI will understate the eff ect

subscrip-of AOL’s Internet subscriptions on the company’s overall profi tability In particular, the optimal policy for AOL is to give up some profi ts on paid subscriptions (i.e., earn a lower ROI on that product) in order to increase profi ts from paid advertising on the AOL Web site (i.e., earn a higher ROI

on that product)

Example 2: When Pfi zer bought Pharmacia Upjohn, it integrated the two sales forces, since the two product lines were related on the cost and demand sides After the merger, it would have been incorrect for Pfi zer to attempt to maximize the separate ROIs for each product line

Fusion for Profi t Maxim

Th e multiproduct fi rm should use a product-line-based measure of ROI if its product lines are related on the cost or demand sides

Time Frame

Th e time frames used to compute ROI should diff er across products

Example: Suppose PepsiCo introduces a new line of soft drinks Th en, PepsiCo may have to advertise the new product line of soft drinks heavily to build demand Hence the new product line will produce a lower ROI in the short run than PepsiCo’s existing products

Suppose PepsiCo uses the same time frame to evaluate the ROIs of all its products Th en, PepsiCo will underinvest in the new product line.

Fusion for Profi t Maxim

Th e ROI criterion is likely to lead to underinvestment in new products unless diff erent time frames are used for established and new products

Uncertainty

Another critical issue is that the standard measure of ROI does not allow for uncertainty As will be discussed shortly, the standard measure of ROI will lead

to poor resource allocation decisions and suboptimal marketing policies

Can the fi rm choose marketing policy to maximize profi ts when

demand and costs are uncertain? Assume that investment is fi xed and that the fi rm produces one product only.

Example: Suppose a privately owned shoe retailer needs to price a new line

of designer fashion shoes it purchases from Nine West Th e problem is that demand is uncertain If the retailer charges a price of $100 per pair, the demand could be either 5,000 or 10,000 pairs of shoes If the retailer charges a lower price of $90 per pair, the demand could be either 8,000 or 12,000 pairs

Assume that the retailer can purchase the shoes from Nine West

at a price of $60 per pair Furthermore, there is no time delay between the time an order is placed and the time that the order is fulfi lled Which price strategy ($100 or $90 per pair) will maximize the retailer’s profi ts?

Consider the price of $100 per pair Depending on the number of pairs sold, the retailer will make a profi t of either $200,000 or $400,000 If the retailer

charges a lower price of $90 per pair, it will make a profi t of either $240,000

or $360,000 (table 1.1)

Comparing the profi ts across both pricing plans, we see that the price of

$100 per pair could lead to the highest profi t ($400,000) However, if demand

is weak, this pricing strategy could lead to the lowest profi t ($200,000).

Fusion for Profi t Maxim

One cannot choose marketing policies to maximize profi ts under uncertainty

If the fi rm cannot maximize profi ts under uncertainty, how should

the fi rm choose its marketing policy?

Th e fi rm should simultaneously consider several factors: the uncertainty in

cash fl ows, its risk attitude, and its ownership structure (i.e., whether the fi rm

is privately owned or owned by stockholders) Furthermore, the fi rm needs

to choose an appropriate metric for measuring profi tability

1.3 How Does the Ownership Structure of the Firm

Affect How Marketing Policies Should Be Chosen?

The Privately Owned Firm

What criterion should the

its marketing policy?

Some marketing strategies are more aggressive than others Hence it is necessary for the fi rm to determine the trade-off between risk and return for each strategy

Table 1.1

Nine West Example: Comparison of Low- and High-Price Strategies

Demand 1 5,000 pairs

Demand 2 10,000 pairs

Demand 3 8,000 pairs

Demand 4 12,000 pairs Revenue scenarios

Example: Consider the case of Google prior to the time it went public Suppose Google had to choose between two marketing strategies Assume that each strategy required the same level of investment.

Under the fi rst strategy (Strategy A), Google could have allocated resources to obtain new customers in a fast-growing but volatile market seg-ment Under the second strategy (Strategy B), Google could have attempted

to increase the retention rate of its current customers

Which strategy should Google have chosen?

Strategy A is more aggressive and could have produced a higher average profi t than Strategy B However, it is much riskier Hence, without quantifying the risks and returns from the two marketing strategies, one cannot determine which strategy Google should have chosen

What is the simplest way for the privately held fi rm to compare

the risks and returns for any given marketing strategies?

Th e simplest approach for the privately held fi rm is to ignore volatility

com-pletely and to choose the marketing strategy for which the expected profi t

is the highest If the fi rm uses this expected profi t criterion, we say that the

fi rm is risk-neutral.

In the Nine West shoe example discussed earlier, suppose that each of the demand levels for the two pricing policies has an equal chance (50%) of occurring Th en, the expected profi ts for both pricing strategies are equal ($300,000) (table 1.2) Hence risk neutrality implies that the retailer will be indiff erent between the two pricing plans

Should the fi rm choose marketing policies to maximize its

Table 1.2

Nine West Example: Effect of Demand Uncertainty on Profi ts

Demand 1 5,000 pairs

Demand 2 10,000 pairs

Demand 3 8,000 pairs

Demand 4 12,000 pairs

Expected Profi t

Note: Each demand scenario's probability is 50%.